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SEC did not properly investigate Madoff’s trading, says inspector general

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In a stinging report summarising the results of an internal investigation into the US Securities and Exchange Commission’s failure to halt Bernard Madoff’s giant Ponzi scheme, David Kot

In a stinging report summarising the results of an internal investigation into the US Securities and Exchange Commission’s failure to halt Bernard Madoff’s giant Ponzi scheme, David Kotz, the SEC’s inspector general, says that the SEC failed on numerous occasions to identify the scheme.

In an executive summary of his report published yesterday on the SEC’s website, Kotz says: "Despite numerous credible and detailed complaints, the SEC never properly examined or investigated Madoff’s trading and never took the necessary, but basic, steps to determine if Madoff was operating a Ponzi scheme.’

Kotz notes that the SEC’s "most egregious" lapse was its failure to verify Madoff’s purported trading with any independent third parties, even after it took testimony from Madoff in May 2006.

The report highlights six instances where SEC investigators failed to properly investigate complaints from credible sources, For example, in May 2003 the SEC’s investment management examination group in Washington, D.C. received a detailed complaint from a hedge fund manager, in which he laid out the red flags that his hedge fund had identified about Madoff while performing due diligence on two Madoff feeder funds.

The hedge fund manager’s complaint identified numerous concerns about Madoff’s strategy and purported returns. According to the hedge fund manager’s complaint, while Madoff purported to trade USD8bn to USD10bn in options, he and his partner had checked with some of the largest brokers and did not see the volume in the market.

Further, the hedge fund manager explained in his complaint that Madoff’s fee structure was suspicious because Madoff was foregoing the significant management and performance fees typically charged by asset managers. The complaint also described specific concerns about Madoff’s strategy and purported returns such as the fact that the strategy was not duplicable by anyone else; there was no correlation to the overall equity markets (in over ten years); accounts were typically in cash at month end; the auditor of the firm was a related party to the principal; and Madoff’s firm never had to face redemption.

According to an SEC supervisor, the hedge fund manager’s complaint implied that Madoff might be lying about its option trading and laid out issues that were "indicative of a Ponzi scheme." One of the senior examiners on the team also acknowledged that the hedge fund manager’s complaint could be interpreted as alleging that Madoff was running a Ponzi scheme.

The inspector general’s expert concluded that based upon issues raised in the hedge fund manager’s complaint, had the examination been staffed and conducted appropriately and basic steps taken to obtain third-party verifications, Madoff’s Ponzi scheme should and would have been uncovered.

In another missed opportunity to halt Madoff, in April 2004 an investment management examiner in the SEC’s Northeast Region Office had been conducting a routine examination of an unrelated registrant and discovered internal emails from November and December 2003 that raised questions about whether Madoff was involved in illegal activity involving managed accounts.

These internal emails described the red flags the registrant’s employees identified while performing due diligence using widely available information on their Madoff investment. The red flags the registrant had identified included Madoff’s: (1) incredible and highly unusual fills for equity trades; (2) misrepresentation of his options trading; (3) secrecy; (4) auditor; (5) unusually consistent and non-volatile returns over several years; and (6) fee structure.

Crucially, one of the internal emails provided a step-by-step analysis of why Madoff must have misrepresented his options trading. The email explained that Madoff could not be trading on an options exchange because of insufficient volume and could not be trading options over-the-counter because it was inconceivable he could find a counterparty for the trading.

For example, the email explained that because customer statements showed that the options trades were always profitable for Madoff, there was no incentive for a counterparty to continuously take the other side of those trades since they would always lose money. These findings raised significant doubts that Madoff could be implementing his trading strategy. The internal e-mails included the statement that the registrant had "totally independent evidence" that Madoff’s executions were "highly unusual."

The investment management examiner and his supervisors viewed the emails as indicating the registrant’s employees were clearly "trying to find out where exactly the trades were taking place" and the emails were evidence that "there’s some suspicion as to whether Madoff is trading at all." They indicated they would have followed up on the allegation in the e-mails about "whether Madoff was actually trading," but this investigation too eventually came to nothing.

SEC chairman Mary L. Schapiro says: ‘Since Bernard Madoff’s fraud came to light last year, the Securities and Exchange Commission’s inspector general has been investigating why the agency failed to detect it. His report makes clear that the agency missed numerous opportunities to discover the fraud. It is a failure that we continue to regret, and one that has led us to reform in many ways how we regulate markets and protect investors.

‘The findings contained in the report reinforce my view that the many changes we have made since January will help the agency better detect fraud.

‘We have streamlined our enforcement procedures and are putting more experienced staff on the frontlines. We also have bolstered our inspection program, started to revamp the way we handle hundreds of thousands of tips received annually, begun to hire new skill sets, increased internal training, and sought more resources to keep pace with financial fraudsters.

‘Although numbers cannot tell the entire story, already we have filed more than twice as many emergency temporary restraining orders this year related to Ponzi schemes and other frauds, as compared to the same period last year.

‘In addition, we have proposed new industry rules that will better protect clients of investment advisers by mandating independent reviews to assure that a client’s account contains the funds that the investment adviser says it contains. And, we have sought legislation to enable us to compensate whistleblowers for providing substantial evidence of wrongdoing.’

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